Transcript Federal Reserve System - Lindbergh School District

Monetary Policy
The fundamental objective is to assist the
economy in achieving a full-employment, noninflationary level of total output.
• The FED alters the economy’s money supply
to stabilize aggregate output, employment and
the price level.
• Monetary policy
— increasing the money supply during a
recession to stimulate spending
— restrict money supply during inflation to
constrain spending.
Balance Sheet Of
The Federal Reserve Banks
ASSETS
• Securities
• Loans to Commercial Banks
LIABILITIES
• Reserves of Commercial
Banks
• Treasury Deposits
• Federal Reserve Notes
Tools Of Monetary Policy
Open-Market Operations
√ Buying Securities
From commercial banks...
• Bank gives up securities
• FED pays bank
• Banks have increased reserves
From the public...
• Public gives up securities
• Public deposits check in bank
• Banks have increased reserves
Tools Of Monetary Policy
Open-Market Operations
√ Selling Securities
To commercial banks...
• FED gives up securities
• The Bank pays FED
• Banks have decreased reserves
To the public...
• FED gives up securities
• Public writes check to FED
• Banks have decreased reserves
Bond Prices and Interest Rates
Bond prices
and interest
rates are
inversely
related.
When FED is buying bonds, the demand
for them increases:
• price of bonds rise and their interest
rates fall
• Lower interest rates causes banks and
other bondholders to sell them to FED.
When FED is selling bonds, the increase in the supply
of bonds in the market, causes:
• price of bonds to fall and their interest rates to rise
• higher interest rates causes banks and other
bondholders to buy them from the FED since bonds
are now a better investment.
Federal Reserve—Buying Bonds
Purchase of a
$1000 bond
from a bank
or from the
public...
New reserves
$800
Excess
Reserves
$4000
Bank System Lending
$200
Required
reserves
$1000
Initial
Deposit
Total Increase in Money Supply ($5000)
Tools Of Monetary Policy
The Reserve Ratio
Raising the Reserve Ratio
• Banks must hold more reserves
• Banks decrease lending
• Money supply decreases
Lowering the Reserve Ratio
• Banks may hold less reserves
• Banks increase lending
• Money supply increases
Tools Of Monetary Policy
The Discount Rate
Raising the Discount Rate
• Banks borrow less from the FED
• Banks decrease lending
• Money supply decreases
Lowering the Discount Rate
• Banks may borrow more from the FED
• Banks increase lending
• Money supply increases
Easy Money Goal: Cheap, available credit;
increase the money supply
Policy
Actions
• FED will
buy
government
bonds from
banks and
the public
• FED will lower the
legal reserve ratio
• FED will lower
the discount rate
charged to member
banks
Results
¦ Increase
the bank
excess
reserves, and
banks can
make more
loans.
An increase in the
money supply will
lower the interest rate,
causing Investment to
increase and
equilibrium GDP to
rise.
The amount of the
change will be
dependent on the
size of the Income
Multiplier (1/MPS)
Tight Money Goal: Restrict credit;
Policy
decrease the money supply
Actions
Results
• FED will
sell
government
bonds to
banks and
the public
¦ Decrease
the bank
excess
reserves, and
banks will
issue fewer
loans
• FED will raise the
legal reserve ratio
• FED will raise
the discount rate
charged to
member banks
An decrease in the
money supply will raise
the interest rate,
causing Investment to
increase and
equilibrium GDP to
fall.
The amount of the
change will be
dependent on the
size of the Income
Multiplier (1/MPS)
Monetary Policy, Real GDP,
the Price Level
Transmission Mechanism
• Money supply impacts interest
rates
• Interest rates affect investment and
some consumer spending
• C and In are components of AD
• Equilibrium GDP and PL are
changed.
Easy Monetary Policy And Equilibrium GDP
Real rate of interest, i
Sm1 Sm2 Sm3
10
10
8
8
6
6
Dm
0
Quantity of money demanded and supplied
PL3
PL2
PL1
0
Amount of investment, i
If the Money Supply
Increases to Stimulate
the Economy…
Interest Rate Decreases
Investment Increases
AD & GDP Increases
AD3(I=$25)
with slight inflation
AD2(I=$20)
Increasing money supply
AD1(I=$15)
continues the growth –
Real domestic output, GDP
but, watch Price Level.
AS
Price level
Investment
Demand
Tight Monetary Policy And Equilibrium GDP
Real rate of interest, i
Sm3 Sm2 Sm1
10
10
8
8
6
6
Dm
0
Quantity of money demanded and supplied
PL1
PL2
PL3
0
Amount of investment, i
If the Money Supply
Decreases to “cool”
the Economy…
Interest Rate Increases
Investment Decreases
AD & GDP Decreases
with lower PL
AD1(I=$25)
AD2(I=$20)
Decreasing money supply
AD3(I=$15)
continues the “cooling” –
Real domestic output, GDP
as Price Level falls.
AS
Price level
Investment
Demand
Strengths of monetary policy
• Speed and flexibility
• Isolation from political pressure
Focus on the Federal Funds Rate
• The Federal Funds Rate
• Recent Monetary Policy
Problems and Complications
•Changes in Control-electronic banking
and flow of funds
•Changes in Velocity—cost of holding
money
•Cyclical Asymmetry—easy to get results
with tight money policy
Monetary Policy And The
International Economy
√ In chapter 12, we learned Fiscal Policy may
be weakened by an accompanying net export
effect which works through change in (a)
interest rates (b) in international value of the
dollar (c) exports and imports.
√ With Monetary Policy, the net export effect
works to strengthen monetary policy actions.
Exchange-rate changes which occur in
response to interest-rate change act to increase
the effect.
Monetary Policy and Net Export Effect
Easy Money Policy
Problem: Unemployment and slow
growth
Tight Money Policy
Problem: Inflation
Easy money policy (lower interest rate)
Tight money policy higher interest rate)
Decreased foreign demand for dollars
Increased foreign demand for dollars
Dollar Depreciates
Dollar Appreciates
Net Exports Increase
Net Exports Decrease
Aggregate Demand Increases
Aggregate Demand Decreases
Effect:
Strengthens Easy Money solutio n
Effect:
Strengthens Tight Money solutio n
√ Monetary policy can also work to aid in reducing
trade deficits since an easy money policy and lower
interest rates causes net exports to increase and this
aids in moving the trade balance closer to equality.
√ But…a tight money policy with higher
interest rates causes net exports to decrease and this
will push the trade deficit higher.
And so… Easy money Policy alleviates a trade deficit,
but aggravates a trade surplus.
But…Tight money policy aggravates a trade deficit,
but alleviates a trade surplus.